10 Audit Tricks the IRS Uses Against You

10 IRS Audit Tricks to Take MORE from You

The IRS has become more aggressive in collecting taxes and has implemented new methods to balance the federal deficit from your pocketbook, including:

More automated Notices (many of them are wrong)

The IRS Automated Under-Reporter Program has been very effective in collecting taxes. In 2011 it collected an additional $1,670 per CP2000 letter without the aid of humans based on a mismatch of information reported to the IRS compared to the income shown on an individual’s tax return.

According to the Treasury Inspector General about half of the people didn’t actually owe the taxes paid because the income was in-fact reported on their tax returns, but IRS computers failed to recognize it. In other cases self-employment tax was assessed on income not from a trade or business (like prizes, awards, rents, settlements and such) or phantom income was added to those with an inactive license based on average earnings of others with that license.

More audits of the working poor and less of the very wealthiest

The working poor with two children may receive up to $9,000 in tax subsidies, such as Earned Income Credit, Additional Child Tax Credits and more, which allows many of them to pay no income taxes while receiving large tax refunds. Due to wide-spread abuse many of the working poor are audited.

The IRS targets zip codes with large minority populations at double the rate of the general population. Many of the working poor earn minimum wage and lack the resources to defend themselves against the IRS. Many may not owe taxes, but their wages are garnished anyway, ruining their credit, costing some their jobs and forcing many into the underground economy (per a Tax Lifeboat study).

Even though the IRS is auditing more high-income taxpayers, audits are way down for the very wealthiest with complex tax returns that include multiple entities, assets overseas and a team of tax attorneys and accountants who know more about the Tax Code than the auditors. According to a web article from Accounting Today (April 14, 2011) Michael Cohn reported that the IRS only managed to audit 13 tax returns of the very wealthiest during the two years prior.

More audits conducted through the mail

The majority of audits are conducted through the mail, which according to the Treasury Inspector General are often “inaccurate and overstated” in which “taxpayers can be assessed extra taxes because their responses don’t get to the right IRS employee in time”. Mail-in audits make it more difficult for taxpayers to defend their case and to connect with the agent working the file. The IRS often “misplaces” information or denies receiving it, resulting in missed deadlines and additional penalties, causing many frustrated people to give up and pay the tax.

Providing worse customer service

The IRS has a couple of mandates which include: 1) assisting taxpayers in being tax-compliant and 2) collecting only the proper amount of tax, but it’s failing in both areas. The IRS has reduced taxpayer services to the point where only half of the calls are answered and those that are require long hold-times.

In addition, the IRS only responded to 48% of its written correspondences within established time frames. When it did respond it often failed to respond to the issues addressed, leaving taxpayers with little alternative but to petition the Tax Court; often over a Notice that was incorrect.

Targeting low-revenue businesses reporting losses

The IRS is auditing the self-employed who report low revenue and show a loss on their tax return. During an audit if there’s not enough income to justify the lifestyle of a business owner and the source of the money can’t be proved, the IRS may add phantom income based on what it believes must have been earned or based on averages of similar businesses, household size, expenses, zip code and other factors. For businesses that claim losses which offset other income, the IRS may argue that it lacks “profit motive” to reclassify the “business” as a “hobby”, disallowing a loss.

Assessing tax on multiple years using the same adjustments

This trick allows the IRS to combine efficiency and collect more taxes. For each area the IRS wins in an audit, expect the same adjustment to the other two open tax years that were not being examined unless you can prove the assessment is wrong. But, that would require you to provide proof and agree to expand the audit to the other two years. At that point most people give up and pay the tax.

For example: During an audit you agreed that you owe $4,500 more for the year being examined. Afterwards the auditor makes similar adjustments to the other two open tax years with the same issues. If the amounts were the same your new tax liability would be triple ($13,500) with accuracy-related penalties added and interest accrued (back to the original due date of the return), which could total about $16,500. What a surprise when you only agreed to $4,500.

Denying deductions through technicalities in the law

The tax code is very complex with many nuances embedded in the law, which gives the IRS a great advantage over you. During an audit the auditor will lead you through a series of questions that may seem routine to you, but some are designed to disallow deductions.

For example: when questioning you about the sale of a rental which showed an ordinary loss of $60,000, the auditor learned that you quit advertising for a tenant shortly before the sale. Why advertise for a tenant when the property is for sale? The problem is that it changed the tax nature of the property.

The auditor accepted your records and allowed the $60,000 loss, but when you stopped marketing the property for rent, its rental nature converted to investment status by the time of the sale, changing the ordinary loss to a capital loss (limited to $3,000) with the balance ($57,000) carried forward to future years. Unless you incurred a capital gain sometime in the future, it would take another 19 years to use up the loss.

Auditing multiple real estate sales to prove dealer status

The IRS is auditing tax returns that report gains from the sales of multiple real estate properties. Most people don’t realize that property bought or built with the intention to resell (such as flipping) makes one a dealer and not an investor. Gains made by dealers are not given favorable capital gains treatment and are instead taxed as ordinary income and subject to self-employment tax.

Re-characterizing S-corps to sole proprietors or partnerships

The IRS is auditing S-corporations to re-characterize them as sole proprietors or partnerships when a company fails to act like an S corp and is deemed to be an alter ego of its owners, thus subjecting all profits to self-employment taxes and eliminating tax favored fringe benefits of the owners who work in the business.

When the IRS audits an S-corporation, it focuses on three primary areas:

Whether the corporate laws of the State of formation were followed regarding minutes, stock certificates, loan agreements, contracts;

Whether the officers were paid a reasonable salary? And;

Whether the company acted separately from its officers and directors.

Issuing a Notice of Deficiency sooner to limit the window for appeals

The IRS is issuing Notices of Deficiency earlier than in prior years to limit a person’s opportunity to appeal their case. The Notice gives 90 days to petition the Tax Court for matters not agreed to or the right is lost, which would require the tax liability to be paid in full before either: